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For most Americans, their home equity is their most valuable asset. Nevertheless, due to soaring inflation, runaway prices for goods and services, plus the huge increase in interest rates, many Americans are now finding themselves in financial straits. When a homeowner is faced with tapping into their equity to meet a financial emergency, the question is: Which option will be the least expensive?
Here are the primary options available to homeowners who have no other option but to tap into the equity in their home.
Sell your home and purchase something smaller
Given today’s market conditions, being forced to sell is the least attractive option. To illustrate this point, on a $600,000 selling price and a $400,000 replacement residence, the closing costs would be approximately $56,000 for the two properties, i.e., 8 percent ($48,000) on the listing side and 2 percent ($8,000) on the purchase.
Making matters worse, if the current loan on the existing property is $320,000 at 3.5 percent and the homeowner applies for the same loan amount on the $400,000 purchase, their payments increase from $1,437 per month to $1919 per month at today’s 6 percent rate. That’s an extra $5,784 per year plus starting the new amortization table where the lender obtains 50 percent of their interest by the end of year 10.
Given these numbers, do everything you can as an agent to help sellers keep their homes.
Home equity sharing companies
Did you know that home equity sharing companies allow homeowners to access a portion of their equity in exchange for a portion of their future equity?
According to Lendedu, the homeowner receives a lump sum payment that can be used however they would like without taking on any additional debt or monthly payments. In return, the investing company gets a percentage of the future value of their home.
Since it’s not a form of debt, the eligibility requirements are more lenient than with a traditional lender, making this an option for homeowners that are self-employed, have poor credit, or can’t afford additional monthly payments.
If the home depreciates in value, the home equity sharing company shares the depreciation.
Here are the Lendedu.com top five picks for companies offering Home Equity Sharing.
- Best overall: Unison
- Best for poor credit: Hometap
- Best for buy-out flexibility: Unlock
- Best homeowner protection program: Noah
- Best for long terms with poor credit: Point
Visit their site for a more in-depth discussion.
Home equity loan or refinance?
Given today’s rates, taking a home equity loan is usually much less expensive than doing a full refinance, especially if your existing mortgage is below 5 percent.
To illustrate the costs associated with each option, assume that you purchased your home in June of 2012 for $250,000 with a $200,000 loan fixed at 5 percent (current rate in June 2012.) The total interest due over the life of this loan is $186,512.
As of June 2022, your loan balance is approximately $163,000. You will have already paid $91,521 of the interest due on this loan — that’s 49 percent of the total interest in only 10 years.
Assume that you now need $37,000 to consolidate your credit card debt and you have no plans to ever sell your home. Your choices are to refinance the entire amount ($200,000 at 5.58 percent) or to obtain a home equity loan of $37,000 at 5.75 percent.) Given how close the interest rates are, it’s significantly less expensive to take out a home equity loan of $37,000 at 5.75 percent for 10 years.
Here’s how the numbers stack up in June 2032 (when the home equity loan would be paid off) and June 2042, when the original first would be paid off.
Consequently, the home equity loan is the least expensive option, especially if rates continue to increase. If your current first mortgage interest rate is less the 5 percent or if you pay off the home equity loan in 10 years rather than 20 years, it will save you even more money.
Refinancing vs. HELOC for people age 62+ (reverse mortgage)
What should you do if you need a substantial part of your equity to fund a major emergency or, if you’re retired, to be able to fund additional costs that your savings, pension, Social Security, stocks or 401K are no longer covering?
Assume your property is currently worth $500,000 and that you need to tap into $230,000 of your equity.
- Scenario 1 is a traditional refinance as discussed above. The loan is at 5.83 percent fixed for 20 years.
- Scenario 2 is a reverse mortgage HELOC for seniors who are 62 or older. These vary substantially based upon the borrower’s age and equity. The current rate I found for this type of loan was 5.18 percent fixed for the first five years and then variable. The loan has no payments and instead, is a negative amortization loan.
While the reverse mortgage has the benefit of no payments, the interest cost over 20 years ($327,503) is more than double the interest you would pay using a traditional refinance ($160,202).
Unfortunately, many seniors are unable to qualify for a traditional refinance loan due to having fixed incomes or increased payments.
Two use cases where an AIO can be a better option than traditional financing
In a recent column, I described how an AIO combines a mortgage and credit line with the easy access of a checking account. See that article to understand the nuts and bolts of how AIOs work before reviewing the two use cases below.
Please note that modeling what happens in an AIO is difficult because the interest rate on the principal is adjusted daily based upon the spread over the one-year treasury bill.
The beauty of using an AIO, however, is that any money you have in your account is applied to your principal loan balance and then the simple interest due on the loan is calculated. These two factors allow you to pay off your loan much faster as compared to obtaining an amortized loan.
This is a huge advantage because almost all real estate loans use amortized interest, which typically repays about 50 percent of the total interest due during the first 10 years of the loan’s amortization. Even worse, the negative amortizing HELOC (as illustrated in the example above) costs over double what a regular amortized loan would.
For the two use cases below, John Haney of Colorado Mortgage Company quoted an AIO rate of 5.29 percent.
Use Case 1: Savings for seniors
AIOs are a type of HELOC. When using a traditional loan as opposed to a HELOC, you must take out all the money you will borrow when the loan closes.
In contrast, AIOs allow the borrower to take out just what they need at any given point. This means the borrower is paying interest on a much smaller amount.
In fact, AIOs allow borrowers to pay simple interest-only during the first 10 years. Again, the interest payment is calculated only on the amount that was taken out of the HELOC as a withdrawal.
To illustrate how this works, assume a senior needs an extra $1,000 a month to cover their increased cost of living due to soaring prices and inflation.
During the first month, the owner would only pay only $52.59 in interest. By the end of year one, the total interest for year one would be $634.80. Now compare this to the minimum payment on the traditional refinance loan for $230,000; the borrower would have paid a total of $13,243 in interest — that’s a savings in interest of $12,608.
At the end of year two, assuming the borrower made no principal reduction they would have borrowed $24,000. The interest payment for year two would have been $1,270.
Compare that to the refinance where at the end of year two, the interest paid a total of $26,112. The total savings ($634.80 + $1,270 = $1904.80 total interest-only for two years on the AIO) vs. the refi is $24,207.
Assuming the senior lives into year 11 of the AIO, they will have to start paying down the principal but it’s approximately 10 percent of the current loan amount each year plus interest that decreases each month as the loan balance is reduced.
Use Case 2: Pay off your mortgage incredibly fast
Haney ran a second simulation using the following data:
- Loan amount is $230,000 (as in the refi and 62+ HELOC loans in the examples above).
- Interest rate is 5.29 percent
- The borrower’s net monthly income to deposit into the AIO is $7,000 per month.
- Borrower has $1,400 left over each month after paying all household expenses, car payments and other expenses.
- Instead of putting the $1,400 into a savings account, the stock market, or a 401K, the borrower keeps it in the AIO.
- Using this approach, the borrower pays back the loan in approximately 7.8 years and pays total interest of $56,186 as opposed to $160,075 on a regular purchase loan — that’s a savings of $103,889.
It’s this difference in paying simple interest calculated daily and using whatever money is left over after expenses each month to pay down the mortgage that makes the AIO so effective in saving borrowers tremendous amounts of money. Moreover, if there is an emergency, the borrower can easily tap into their equity by merely writing a check.
Please keep in mind that AIOs are only for those who have credit scores of at least 700 and who are extremely disciplined about using the AIO to build wealth — not making withdrawals to spend on vacations or luxuries.
The bottom line
While an AIO may often be the best option to tap into your equity, many borrowers may be unable to qualify. For those borrowers who are not eligible for an AIO, looking into a home equity sharing company may be a viable option as well as keeping your current first in place and obtaining a home equity loan.
The two most expensive options for tapping into your equity are the traditional refinance, or the costliest decision, obtaining a negatively amortizing HELOC.